Lending Mandates A Bad Idea

Noted banking expert and popular popper of gas balloons, Bert Ely, weighed in on the issue of banks not using TARP money to make loans, with an opinion piece published in the most recent edition of The Wall Street Journal. Bert's opinion is clear: Congress should not mandate any specific uses by banks of any funds received from TARP's Capital Purchase Program.

After observing that Treasury has done a terrible job of explaining to the public how banks use capital (and why, I ask, should Treasury do a better job of explaining that issue than its done with any other aspect of the TARP), Bert does Treasury's job for it by explaining those uses in terms even dummies like the authors of this blog can understand.

Bank capital, which also includes common stock and retained earnings, serves as a cushion to absorb losses from loans and other bank activities; it is not loaned out directly. Most bank lending is funded by customer deposits and borrowings from third parties (such as the Federal Home Loan Banks).

Potentially, a bank could use its increased capital from TARP to absorb losses from loans and investments already on its books, to acquire banks too weak to remain independent, or to increase its lending. The higher capital boosts a bank's lending capacity because it enables the bank to safely increase its deposits -- and thus its loans -- without increasing its risk of insolvency.

Bert recognizes that there has issued forth from the mainstream press, the hallowed halls of Congress, and from Joe Sixpack, a stream of caterwauling that the TARP funds should be used by banks to make new loans. Bert's explanation clarifies that what all the moaners actually should be seeking is that the new capital be used to support borrowings, which, in turn, will be used to make new loans. The incoming Congress and Obama Administration may very well enact legislation to mandate that banks do just that, and, as we've previously discussed here and here, Section 5.3 of the Securities Purchase Agreement used in the CPP gives the Treasury the right to amend existing agreements to meet such federal legislative mandates. Enacting such legislation would be a bad idea, Bert opines, for three reasons.

First, even well-managed banks are suffering loan losses as collateral values shrink and the recession deepens. In normal times, a bank would raise new capital to offset those losses. However, the capital markets are not functioning normally, with many sound banks now unable to raise fresh capital.

TARP investments, which increase a bank's capital, therefore serve as a bridge to when normality returns to the capital markets. Because of restrictions accompanying TARP investments, and a jump in the TARP dividend rate after five years to 9% from 5%, banks will have an incentive to raise private capital to finance a buyback of their TARP preferred stock. Taxpayers will profit from these TARP investments because of the dividends paid by the banks on the preferred shares the Treasury purchased.

Second, weak banks need to be acquired by well-managed banks rather than being propped up by TARP investments, for weak banks are not good lenders. The continued existence of weak banks will impede the economic recovery.

However, an acquirer needs to realistically account for losses buried in the other bank's balance sheet even though this accounting will reduce its own capital. The TARP investment should therefore ensure that the merged bank is well capitalized. Eventually, that bank would raise capital to retire its TARP stock.

Third, while a TARP investment increases a bank's lending capacity, lending mandates -- such as that a bank must increase its outstanding loans by some multiple of its TARP investment -- could force banks to make new bad loans.

Essentially, Bert asserts that banks are in the same business other businesses are in: making money. They deploy capital to maximize value for their stakeholders, and they do that in ways other than simply making loans. They need the flexibility to choose how best to allocate their capital under changing circumstances.

Bert also asserts that "contrary to popular and political opinion, banks have not stopped lending." While he cites a 4.9% growth in commercial bank lending between August and late December to support his position, I wonder what the percentage would be if the starting date was October, rather than December. Nevertheless, whether or not lending is slowing, banks must be allowed to make sound business judgments as to how best to allocate capital without being hamstrung by mandates that could make matters worse.

Given the gas that typically blows out of D.C., and the Gumby-like nature of politicians, who bend with the prevailing popular wind rather than lead from a position of informed leadership, I wouldn't count on such a cautious approach carrying the day. Some people love to beat on banks, especially people who know little about how banks actually work. That would include practically every member of Congress.